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Home » Hgh » High yield and QE: Making money from the domino effect – Investment Week

As we buy assets, investors are likely to substitute the lower risk assets we buy with riskier assets Mario Draghi, President of the European Central Bank, 21 November 2014

Quantitative easing has been the clear policy tool of choice for global central banks since the Global Financial Crisis. This has become even more the case in recent times as interest rates are already at (or through) zero, and therefore the marginal benefit to cutting interest rates further is lower.

The response by central banks to the Coronavirus crisis this year is symptomatic of this - as the chart below shows, the Federal Reserve increased the size of its balance sheet by over double the amount it increased during the financial crisis. This level of quantitative easing is unprecedented, and I believe will have unprecedented impacts upon global fixed income markets.

So we have over a decade of experience with QE - what would we expect the outcome to be of a massive increase in its scale? The immediate impact a decade ago was to drive investors out of short-term government bonds into longer-dated securities - then as yields on these compressed investors switched again from holding government bonds into investment grade corporate bonds with higher yields.

This domino effect - with QE driving yields lower on one segment of the market, forcing investors into another segment, in turn driving yields lower and forcing investors to continue moving on - has been the key driver of fixed income markets over the past decade.

To give some insight into the scale of investor appetite for investment grade corporate bonds since the Global Financial Crisis - the BoAML Global Investment Grade Corporate Bond Index saw its total market value grow from $4.7bn in November 2008 just before the Federal Reserve began its first QE programme, to $12.1bn at the end of February 2020 (just before the launch of the Coronavirus QE programme).

Over the same time period, the yield on this index went from 7.0% to 1.9%. The clear impact of QE over the past decade has been to aggressively encourage investors out of safer securities and into riskier securities, and the investment grade corporate bond segment of the market has been the key beneficiary of this.

Now, you may ask - well this surely cannot be healthy, and surely it will have to all unwind? Well, central banks are more concerned about the health of our financial systems than anyone else, and this action of forcing investors out of low-risk investments and into higher-risk investments is precisely what central banks are trying to encourage. This phenomenon allows companies to raise capital for investment, avoids companies having to worry about refinancing debt, and enables investors to have longer time horizons when making investment decisions.

All of these are healthy and desirable qualities for a financial system to have. With respect to high yield in particular - the Federal Reserve became the first major central bank to explicitly incorporate the buying of high yield debt as part of its QE programme in March this year. Yield compression of riskier parts of the fixed income market is not an unwanted side effect of QE, as many commentators would have you believe - it is the core principle of the policy.

I think you' have probably seen where I am going with this, but to round out the circle - is high yield going to be the next segment of the fixed income market to significantly benefit from the QE domino effect? In answer to this I would highlight the chart below - the blue line shows the relative performance of European high yield versus. investment grade in the two years following the announcement in March 2016 that the ECB would, for the first time in its history, be buying investment grade corporate bonds.

As can be clearly seen the significant outperformance of high tield only began around 200 days after the ECB's announcement. The orange line shows the same relationship for US high yield and investment grade bonds following the Fed's announcement in March that they too will be buying corporate bonds for the first time in their history.

If we follow a similar path to the relationship seen in 2016/2017 we could see significant outperformance of high yield in future. Remember, high yield is the last place in fixed income that offers relatively elevated yields - and will act like a magnet for fixed income investors, just as investment grade bonds did over the preceding ten years.

In short, I believe hgh yield could be the next domino for QE to push over - and therefore it potentially offers investors in the asset class significant upside.

The Artemis fixed income team

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High yield and QE: Making money from the domino effect - Investment Week

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Home » Hgh » High yield and QE: Making money from the domino effect – Investment Week